Let’s begin with this important fact: for the year 2014, there will be a 40 percent federal “death” tax on estates larger than $5.34 million per individual ($10.68 million per couple). Of course, the majority of Americans are passing a smaller amount to their heirs. Accordingly, most of us who plan on receiving an inheritance can rest assured that the federal government will not be taking a cut. Keep in mind, however, the state in which you live may tax your inheritance. Colorado does not impose any estate or inheritance tax. For an overview of state-by-state inheritance taxes, click here.
If you are an individual fortunate enough to be a beneficiary of a 5 plus million-dollar estate (in all or in part), your share of inheritance may be less than you thought because of the federal estate tax. Let’s rewind and see how it all works.
Calculating Federal Estate Tax
The federal estate tax is a tax on your right to transfer property at the time of your death. In order to determine if your estate is subject to this tax, the federal government first performs an accounting of your gross estate, which is the total fair market value of all your property interests at the time of your death. This will include cash, bank accounts, real estate, stocks and bonds, insurance, trusts, annuities, business interests and other assets.
After calculating your gross estate, certain deductions are made. Typical deductions include the marital deduction, funeral expenses, estate administration fees, charitable deductions, and claims against the estate, such as paying off the balance of a mortgage. After subtracting these deductions from your gross estate, you are left with the taxable estate.
Once you have determined the size of your taxable estate, you can figure out how much is exempt from taxation. The personal estate tax exemption, a dollar amount set by Congress, is $5.34 million for 2014. See historical amounts in “Mo Money Mo Taxes – Part 2.” For most of us, our estate will fall below the $5 million mark and will pass to our heirs tax-free (not including potential state tax liabilities).
Marital deduction: Spouses inherit tax-free
When a married person passes away, the marital deduction allows all property left to the surviving spouse to pass tax-free. No matter the size of the decedent’s estate, the surviving spouse will not fork over any amount to the federal government. This unlimited marital deduction is allowed because the federal government plans to collect taxes once the surviving spouse dies.
Warning: If your spouse is not a U.S. citizen, the marital deduction does not apply. The federal government does not want a non-citizen inheriting a sizeable estate from their American spouse and moving to their home country without ever paying an inheritance tax. Without proper planning, any inheritance a noncitizen receives from their American spouse greater than $5.34 million will be subject to a 40 percent estate tax. Paying estate taxes upon the death of the American spouse can be delayed, however, by setting up a Qualified Domestic Trust (QDOT).
Portability provision: How to inherit $10.68 million tax-free
The portability provision allows any unused part of the $5.34 million exemption to pass to the surviving spouse. For example, assume Tom and Pat are married and have their assets jointly titled. When Tom dies, the unlimited marital deduction will allow Tom’s share of the assets to transfer to Pat without being taxed. Tom’s $5.34 million tax exemption was not used and may be added to Pat’s tax exemption. Pat can now bequest to her heirs up to $10.68 million without being taxed by the federal government.
Warning: Pat will not automatically inherit Tom’s unused exemption. She must file IRS Form 706 within 9 months of Tom’s death in order to obtain his unused tax exemption. Pat may receive a 6-month extension by filling IRS Form 4768, allowing her a total of 15 months to file Form 706.
Next up…Mo Money Mo Taxes: The Federal Estate Tax – Part 2